Curmi & Partners

Making sense of it all.

by David Curmi

As we inch towards the end of 2020, there is a sense of relief, not only that 2020 is coming to an end, but that it is also ending with the positive news that a vaccine is now in the process of being delivered, and in some countries also administered.  It has indeed been a torrid year with the virus wreaking havoc to lives and livelihoods.  Our social habits have also been impacted significantly.  As humans we love to interact with friends and family, yet we have had to find new ways to show affection.  No more kissing or hugging or shaking hands.  It is fist or elbow tag now.

From an economic perspective the impact has been tremendous with many economies expected to shrink by 3-11% over the course of 2020.  This type of contraction is second only to that of the Great Depression in 1929.   As a country that relies heavily on tourism and hospitality, Malta has also been hit hard.

Yet, counter intuitively, this severe contraction in world economies has not translated into the type of falls in equity markets that one would have expected.  To give some perspective, in the Great Depression, the S&P lost 89% of its value from peak to trough and took some 25 years to recoup this level.  Although we are still in the first year, the performance of major world equity indices in 2020 has indeed been impressive with the S&P actually rising 14.4% through to 15th December while the Euro STOXX 50 index is down just 5.5% over this period.  How do you explain this surprising performance against such a dire backdrop?

The answer lies in the joint actions of the central banks and governments.  At a high level, the objective that both institutions set out to achieve was that of preserving demand of goods and services, to the extent possible.  This entailed protecting jobs and companies through direct financial support and through grants.  It also meant slashing interest rates, to zero and below, and continuing to pump money into financial markets through the purchase of bonds, at record rates. These last two factors have important consequences for equity markets. 

Firstly, as interest rates fall, prices of bonds rise, making them more expensive.  Their yield also falls as prices rise, with a vast array of bonds now in negative yield territory. Institutional and in many cases retail investors are thus faced with the choice of holding cash, on which they may be charged negative rates by banks, or ostensibly investing into assets such as shares, where a dividend income may be earned.  This creates demands for equities.

Another impact of falling interest rates is to make equities more valuable as lower interest rates not only mean lower borrowing costs for corporates but they make future profits more valuable today, through the discounting mechanism. And if companies can actually return to growing their profits once again then one can justify the current prices on equities.

The other reason for the strong performance of the indices mentioned above, and also the reason for the disparity between US and European equities, is the strong returns registered by technology companies.  One effect of Covid has been a shift, most likely permanent, in the way we go about our lives.  Technology is today a much bigger part of our lives, in almost every aspect.  What we have lost in personal contact we have replaced through video conferencing!

The key question is whether valuations are indeed sustainable.  To answer this question one needs to assess whether corporate profits will grow again, and to a sufficient extent to outweigh any potential rise in interest rates.  If central banks are able to keep their low for longer (interest rates) objective or corporate profits do indeed grow sufficiently, then we could see further growth in equity markets.  If this does not occur then investment strategies need to be adjusted as both bonds and equities could have a tough time. Financial markets in 2021 could be just as eventful as 2020.  Hopefully, the arrival of the vaccine will bring some peace and tranquility into our personal lives.  

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.